How To Hedge Your Portfolio Against Disaster

Global markets are on a roller coaster ride, and the cacophony of advice is confusing. Some pundits warn investors to brace for deflation, or even hyperinflation. Others say the real risk is another depression.

None of us has a crystal ball, but you don't need one to know you should be careful with your savings. To me, it seems smart for an average 40-year-old investor to hedge at least 10% of his portfolio against disaster. The older you are, the more you should hedge.

One potential crisis is another Great Depression. This would be the bigger, badder brother of the recent financial crisis in which global gross domestic product plummeted. The effect would likely be persistent deflation.

We are currently experiencing slight deflation, according to government statistics. The Labor Department says core Consumer Price Index numbers declined 0.1% in January, marking the first decrease since 1982. Looking forward, inflation is likely to be lower in 2011 than in 2010: 2.14% vs. 2.25%, according to a recent Bloomberg survey of economists.

Hedging against deflation:

Cash: This is the only asset that is bullet-proof against deflation. For true worrywarts a mattress is the safest place to keep it since your dollars won't do you much good locked up inside a vault if the government declares a bank holiday. For the slightly less worried, short-term Treasuries are the next best thing to cash.

High-Quality, Dividend-Paying Stocks: These include stocks that pay you money on a monthly, quarterly or annual basis. Study after study shows that stocks that pay dividends hold up better in market downturns than those that don't. Exchange-traded funds that give you easy exposure to dividend payers include SPDR S&P Dividend (SDY), PowerShares Dividend Achievers (PFM) and mutual funds like the Eaton Vance Dividend Builder Fund (EVTMX).

Gold: This metal is often regarded as an inflation hedge, but it also holds up well during deflation. This is because fearful investors put hard assets, as well as cash, at the top of their to-own lists. That said, gold is more speculative than cash and dividend-paying quality stocks.

What about municipal and corporate bonds? They have proven to be safe havens against deflation in the past, but given the unstable state of the banking system you might want to avoid them this time around.

Another way to hedge against a market collapse is to use inverse ETFs, which gain when stocks decline in value. The ProShares Short S&P 500 (SH) is a good example. It uses derivatives to produce a return that is roughly the inverse of the S&P 500's. A word of caution: Inverse funds aren't for casual investors. You need professional guidance to use them. The same goes for put options, which are another way to short the market.

Hedging against inflation and hyperinflation:

The government solution to deflation is to throw so much money at the economy that deflation goes away. The side effects are ballooning government debt. Throwing money at problems can work, but it's hard to manage the smooth transition from deflation to inflation. If things get out of hand, we could face a high rate of inflation. If things really go off the rails, then we could see hyperinflation.

The U.S. got its last taste of rampant price increases in the 1970s. A basket of goods that cost $100 in 1970 cost $212 a decade later, according to the Bureau of Labor Statistics.

Gold has a pretty good record as an inflation hedge. Gold miners are a good bet, too. Suppose you buy shares of a mine that produces gold for $450 an ounce and prices rise from $1,100 to $1,500 an ounce--a 36% gain. Your mine's gross profit margin has jumped to $1,050 an ounce from $650 an ounce. That's a 61% gain.

Funds that hold baskets of gold miners include the Market Vectors Gold Miners ETF (GDX) and US Global Gold and Precious Metals Fund (USERX). One thing to keep in mind is that the performance of gold, and gold miners, is very lumpy.

Gold hit a high in 1980 of $875 per ounce and then fell as low as $463 within a few months. Gold again hit $700 by 1982 and then fell to a low of $298 per ounce. Behind the volatility: high inflation that pushed up gold prices and a deceleration of inflation that undercut the price of the yellow metal.

If you're unsure which is the greater risk--deflation and depression or inflation--the real question is how to hedge simultaneously against both.

Energy: the all-weather investment.

In times when economic growth and prices are on the rise, oil prices and oil stocks often outperform. Even if these factors aren't putting a lot of pressure on energy prices, I expect them to trend higher over the long term anyway. That's because new finds are increasingly expensive to extract. The gains won't be in a straight line. Instead, oil price spikes seem to bring about economic declines, which in turn weigh on oil prices. When it comes to oil, you might want to buy the dips and sell the rips.

Funds that hold baskets of oil stocks include the Energy Select Sector SPDR (XLE). But just two companies, ExxonMobil and ChevronTexaco, account for around one-third of this ETF's assets. Another option is the Rydex S&P 500 Equal Weight Energy (RYE), which holds the same stocks as XLE, but only allocates 2.5% to 4% to any one stock.

What you can take away from all this is that it's important to be flexible, spread your risk, expect the unexpected and hedge your bets in case what you expect to happen turns out to be dead wrong.

Sean Brodrick, a natural resources analyst for Weiss Research, Inc. and contributor to Uncommon Wisdom Daily, is author of The Ultimate Suburban Survivalist Guide: The Smartest Money Moves to Prepare for Any Crisis (Wiley, 2010).